The government has the intention to embark on a spending spree and intensify opposition against Brussels, but not to leave the Eurozone. This risk, though, cannot be fully neglected

The short-term economic impact of the current turmoil is expected to be limited. Predictions for the long term are difficult to make at this point, but risks are clearly to the downside

Five Star and the League reach deal with President

And then it happened… After almost three months of a political tug-of-war, the President approved a Five Star-League government on late Thursday night. Today at 4pm, President Mattarella will install the populist cabinet led by Giuseppe Conte. The government will then face a confidence vote in Parliament early next week. The vote will pass and Italy will have to prepare for a government with the intention to embark on a spending spree, to intensify opposition against European budget rules, and to take harsh actions against refugees. Both parties have insisted in the past few days that they won’t call for an exit from the euro. The initial market reaction is therefore mildly positive. The 10-year BTP-Bund spread is off its highs but remains elevated at 220 basis points and the main Italian stock indices are up c. 2% this morning.

The coalition had initially pulled the plug when Mattarella refused to appoint Mr. Savona – a eurosceptic – as Italy’s Finance Minister. Snap elections seemed very likely until Five Star and the League were able (and willing) to put forward Giovanni Tria, a professor in economics, for the job. Tria is in favour of Italy’s Eurozone membership, but also thinks that reform of the monetary union is necessary in order to guarantee its survival. Mr. Savona will be Minister of European Affairs. On the upside, the pro-European Enzo Moavero Milanesi will be the next Minister of Foreign Affairs. Five Star’s leader Di Maio himself will be installed as Minister of Labour and Industry and League leader Salvini as Minister of Interior Affairs. Accordingly, Di Maio will be the one to oversee the implementation of Five Star’s flagship (conditional) citizen’s income, while Salvini is the one in charge to implement the League’s harsh migration policy.

Will the government start printing Lira’s?

While we recognise that the risk of a Euro exit has increased, we still think that the probability is small. We have always argued that the government is unlikely to deliberately leave the Eurozone, and in the past few days they have told anyone who wanted to listen that getting back to the Lira was not their intention. Furthermore we think that different ideologies and the combination of inexperienced policy makers with the difficulty of implementing several of the proposed measures will slow the actual implementation of their policies. And finally, we believe they would eventually cave in to pressure from the financial markets and the constitution, if they try to push their too expansive policy agenda (box 1), by watering down the measures or breaking up the coalition.

That said, the risk of a crisis and, eventually, an accident that pushes Italy over the edge has increased. While euro exit is not the goal of the current leadership of Five Star nor of Salvini, there are certainly flanks within both parties that are in favour. Hence, should the country end up in a situation of untameable market turmoil, the euro exiteers within the parties might be able to convince the coalition not to accept conditional financial support from the Eurozone, not to step aside and that in fact printing Lira’s and euro exit is the only way to go. It goes without saying that this would cause major problems for both Italy and the Eurozone.

However, even if it does not come to an actual Euro exit, the populist coalition could severely damage Italy’s debt sustainability and longer term growth prospects. Yet at this point, future policy and the implementation thereof is too uncertain to be able to make long-term predictions.

Box 1: The expensive government contract of Five Star and the League

Two weeks ago, Five Star and the League had published a government contract. In a previous publication we have already described the most expensive fiscal and economic policy measures. In this box we give a brief summary. We have looked at the estimations of the costs by several institutions and economists of the flat income tax, the so-called citizens’ income, and a reversal of the 2011 pension reform. The two-tier flat tax rate is estimated to lower government tax receipts by between EUR 50bn and EUR 102bn a year. Estimates for the cost of a citizens’ income of EUR 780 a month range from EUR 15bn to EUR 30bn a year. A reversal of the 2011 pension reform, known as the Fornero law, would effectively imply a fall in the retirement age, leading to additional pension spending of around EUR 20bn a year. These costs would come on top of the deficit-reducing measures of around EUR 12bn the coalition would need to implement to prevent the VAT rate to automatically increase in January 2019, which both parties have pledged to do. In a ‘worst case scenario’, the government would need to find additional financing of between EUR 100bn and EUR 152bn a year, i.e. between 5.8% and 8.8% of GDP.

Will the economy care?

In the short term, we expect the Italian economy to suffer a bit from the current uncertainty. Manufacturing sector and consumer confidence are already under pressure, though still relatively high from a historical perspective. Italians are rather used to policy uncertainty, so overall confidence effects could be limited. But especially foreign investors might choose to take a wait-and-see stance. Meanwhile, increased interest rates could constrain credit growth and have a small dampening effect on economic activity. But as businesses have quite some internal funds the impact of more expensive credit costs on investments could be limited. At the same time, if the government actually manages to lower taxes and increase spending, this could provide some boost to the economy.

All in all, our forecast of 1.3% of growth this year and 1.1% next year is now under review, but we need to see more data before we will alter our forecast.

Figure 4: Confidence slides, but is still relatively high from a historical perspectiveSource: Macrobond, Rabobank

The risks for the economy in the long term are clearly tilted to the downside. At best should we expect that some minor tweaks to simplify the tax system and lower the tax burden, and a ‘conditional’ basic income have some positive impact on economic growth, while a significant deterioration of public finances will be prevented. At worst, fiscal slippage spirals out of control and previous pension reforms are being rolled back, worsening debt sustainability and as such the economic growth outlook in the longer term. Even if fiscal slippage would be contained, this government, which is looking to please many interest groups and has little experience, seems ill-equipped to deal with Italy’s structural problems, to increase the low potential growth rate and to make the country less vulnerable to shocks.

In fact, if financial turmoil returns to levels seen during the debt crisis it is very unlikely that the government is able to navigate the country out of a crisis. At this moment we don’t think debt sustainability will become an issue in the foreseeable future. But, the large debt stock makes the country vulnerable to shocks and especially if pension reforms will be rolled back, medium and long-term debt sustainability could become an issue.

Is the Eurozone (economy) in trouble?

In the short term, the impact on the economy of the Eurozone is rather limited. The extreme budget proposals of Five Star and the League could have an impact on investment intentions in other Eurozone countries if businesses believe the monetary union and financial stability are being put at risk. But we believe it is too early to draw this conclusion. The probability of actual execution of the (full) programme needs to increase before we should expect some sizeable effect.

More in general, we think that the government will strike a more defiant tone towards Brussels and will try to stretch flexibility of the European budget rules even more than in the past. Their budget proposals are completely out of line with the European budget rules (box 1), even if only implemented in a watered down version. Furthermore, the two parties have mentioned in their draft government contract that they want to radically reform the stability and growth pact and the fiscal compact. With such a government in place, plans for more risk sharing within the EMU, such as the European Deposit Insurance Scheme, will face further headwinds especially by those member states loath to take on more shared risk. Based on what we know now, the likelihood that this new government will significantly lower government debt and improve banking sector stability seems very low. This, however, is likely to be necessary to convince to convince Northern Eurozone Member States of the benefits to increase mutual risk sharing in the currency bloc.

Importantly, we stick to our view that it is unlikely that Italy will actually leave the Eurozone, although the risk cannot be fully neglected as explained above.